In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Golden Wheel Tiandi Holdings Company Limited (HKG:1232) is currently trading at a trailing P/E of 2.5x, which is lower than the industry average of 6x. While this makes 1232 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
See our latest analysis for Golden Wheel Tiandi Holdings
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for 1232
Price-Earnings Ratio = Price per share ÷ Earnings per share
1232 Price-Earnings Ratio = CN¥0.64 ÷ CN¥0.255 = 2.5x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 1232, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since 1232’s P/E of 2.5 is lower than its industry peers (6), it means that investors are paying less for each dollar of 1232’s earnings. This multiple is a median of profitable companies of 24 Real Estate companies in HK including Fullsun International Holdings Group, Top Spring International Holdings and Chinney Investments. You can think of it like this: the market is suggesting that 1232 is a weaker business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to 1232. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 1232, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 1232 to are fairly valued by the market. If this does not hold true, 1232’s lower P/E ratio may be because firms in our peer group are overvalued by the market.